Fragile Finance: Debt, Speculation and Crisis in the Age of Global Credit

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Item Added: Fragile Finance. View Wishlist. Our Awards Booktopia's Charities. Most recent financial crises, including those in East Asia, Russia, as well as corporate scan- dals associated with the dotcom bubble, Enron, WorldCom, Refco, Parmalat, and to some degree Northern Rock and the credit crunch, can be attributed at least partly to the opacity of current accounting practices and the use of tax haven affiliate entities for either fraudulent or opaque purposes. Securitization and derivitization, as well as mortgage broking, generated sub- stantial fee income, thus feeding the growth of a parallel system of raising funds.

Many shadow banking units serve to draw in short-term funds from foreign banks and from money market mutual funds in order to lend long, just as commercial banks traditionally have done Mullineux 5. In its function, therefore, the shadow banking system has not only provided an alterna- tive market-based way to raising funds; being tightly intertwined with the offshore financial world, the shadow banking system has helped conceal those financial innovations that are deemed illegal,14 for instance in the U.

Fragile Finance

The crises also contain a more critical dimension: negligent executives and fraudsters do not only deceive investors; they leave many workers without pensions and jobs, and have effects on the entire economy. The economy ultimately bears the resulting costs without having enjoyed the risk premiums created during the boom. The offshore entities that seem to have caused most of the problems are the special purpose vehicles or entities SPVs or SPEs, respectively.

This ghost company is typi- cally set up for the purpose of buying receivables and issuing bonds which may be backed by those receivables. In most instances it will be situated in an offshore jurisdiction. Alternately, a 14 Nwogogu argues that securitization constitutes several violations of U. Constitution; it constitutes a violation of the right to contract clause of the U.

Constitution and hence is illegal; it constitutes a violation of the equal protection clause; it constitutes a violation of the separation of powers doctrine. SPEs raise severe prudential problems. First, while tax havens have made it exceedingly easy to set up offshore SPEs, these jurisdictions do not have the resources, especially in terms of staff, to perform appropriate due diligence on operations that in reality are highly complex financial vehicles.


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For example, the banking system of the Cayman Islands, a country whose budget needed to be rescued by emergency loans in , holds assets of over times its GDP. Jersey, another offshore haven, holds assets worth over 80 times its GDP. It is highly question- able whether these and other small jurisdictions can allocate sufficient resources to monitor and regulate such colossal sums of money. The second prudential issue related to SPEs is the potential to accommodate fraud that secu- ritization structures offer. Haynes documents many instances of offshore bond issues or similar arrangements being used to fleece investors of money which then disappears.

Some of these cases involved banks being successfully asked to guarantee an SPV. They were then left with the financial liability when the funds raised by the vehicle disappeared along with those behind the scheme Haynes As the author explains, one advantage a secondary secu- ritization vehicle provides to a fraudster: is a plausible reason for the bond issue being made from an offshore centre, [typically offering] a good combination of low taxes, efficient communication, a convenient time zone, a wide range of double taxation treaties, easy access to the core financial markets such as USA and a tradition of SPVs being based there.

What they also offer the fraud- ster is a regulatory system that is not always as effectively enforced as it could be. Once the bond issue has been made, the funds could disappear and the fraudsters with them. Haynes SPEs hit the headlines following the collapse of Enron. Senate Nevertheless, despite headline reports, neither the Powers report nor the congressional hear- ings have demonstrated that offshore structures were palpably more poisonous that the onshore ones in the Enron case. Against this background, the global crisis of , and specifically the collapse of the British bank Northern Rock in autumn , raised further questions about the nature of offshore SPVs and their role in the current financial crisis.

The transfer of the assets to the first SPV 1 will be a true sale for the purposes of bankruptcy risk and those assets are then transferred to SPV 2 in a transfer that is a true sale for the purposes of the relevant accounting rules. SPV 2 then proceeds to issue the bonds. On termination of the arrangement, when the bonds are paid off, SPV 2 can re-transfer any outstanding receivables to SPV 1 which may itself then be hived up absorbed into the originator.

Northern Rock and Granite Northern Rock was a UK mutual building society that was converted into a public limited com- pany in Building societies typically raised the money they lent in a rather conventional fashion, by attracting it from depositors. Banks, on the other hand, have the option of accessing larger sums from the money markets somewhat more easily. After demutualization Northern Rock became a bank, and in early became the fifth largest mortgage lender in the UK. It was quite distinct from conventional commercial banks in that it had a small deposit base and relied heavily 75 percent on wholesale money markets to get the funds.

It was this aggres- sive strategy of financing that brought Northern Rock its prize for the best securitization deal of the year in January The trust in question was the Down Syndrome charity in northeast England.

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After the failure of the company it became clear that this charitable trust had never paid anything to the charity, and that the charity meant to benefit from it was not even aware of its existence. Granite was, therefore, solely responsible for the debt it issued. The arrangement was but a sophisticated masquerade, and one that was helped by the fact that the trustees of the Granite structure were, at least partly, based in St. Helier in Jersey. When journalists tried to locate these Granite employees they found there were none in Jersey.

The entire structure was acknowledged to be managed by Northern Rock, and therefore and unusually was treated as being on the balance sheet of Northern Rock and hence included in its consolidated accounts. Experiencing the first shockwaves of the global financial crisis, Northern Rock faced a dilemma. Granite was used to securitize parcels of mortgages on the money market through bond issues. Consequently, Northern Rock had to support Granite in meeting the obligations Granite had entered into with its bond- holders, even though the company was notionally independent.

The same confusion arose as to whether Granite was onshore or offshore. In practice the arrangement included elements of both. When the crisis of the bank broke out, debates at the House of Commons ran well into the night on whether the nationalization of Northern Rock also meant the nationalization of Granite.

The details of the ownership structure of Granite companies and its financial rela- tionship with Northern Rock remain murky to this day. Because Granite is a Jersey-incorporated vehicle, and due to the secrecy laws of Jersey there was no way of finding out who precisely was Downloaded from rrp. As a result, the issue was never resolved. After the bank was nationalized, no one seemed to know whether a company wholly managed by the state-owned enterprise but notionally owned by a charitable trust was under state control, or not.

Despite that, the UK government had little choice but to extend its guarantee to the Granite bond holders. What is more or less clear is the fact that the Jersey-based offshore structure was used as a secu- ritization vehicle for mortgages issued by Northern Rock. It is also implied that Granite served as an equivalent of a price transfer channel for Northern Rock, a means through which the bank could transfer profits earned in the UK to the near-zero tax regime of Jersey. The way securitisation works… is you borrow against a pool of mortgages. The separate legal entity is a matter of trust.

Cited in Tomasic What Applegarth did not mention is that Northern Rock did not carry the risk either, because the risk was nominally removed to its SPE. Such schemes are commonplace throughout the financial system and have been widely used in the securitization of sub-prime mortgages. The rationale for banks and financial institutions to employ such schemes goes far beyond capitalizing on the benign tax regimes offered by offshore jurisdictions. The main reason why such schemes have been used across the financial system has to do with the liquidity of the newly created asset-backed securities.

Indeed, from the very beginning of the securitiza- tion boom, a central concern in facilitating the marketability of securitized debt has been to enable the rating agencies to analyze and grade the credit risk of the assets in isolation from the credit risk of the entity that originated the assets. The purchaser of the assets is typically an SPV, such as Granite.

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Curiously, Northern Rock was a relatively clean case compared to many. In order to obtain good ratings on its mortgage-based securities, the bank set up two SPVs. The name of the Down Syndrome charity, the nominal beneficiary of the scheme, was used as SPE1 for the purposes of bankruptcy risk. The assets were then transferred to the second SPV, Granite, a transfer that is a true sale for the purposes of the relevant accounting rules.

The financial crisis: a decade of debt - PunkFT

SPV2, Granite, then proceeded to Downloaded from rrp. On termination of the arrangement, when the bonds are paid off, SPE2 Granite can re-transfer any outstanding receivables to SPE1 Down Syndrome charity which may itself then be folded back into the originator. The delinquency of Northern Rock revealed the great complexity of dealing with the resulting situation on the part of almost every regulator who approached the scene; and this ambiguity has remained even after the bank was nationalized by the UK government. While the UK govern- ment may have settled the issue of Northern Rock, despite the great ambiguities in its relation- ship to Granite, the existence of so many orphaned SPEs, holding billion upon billion of debts, yet legally separated from their onshore parents, has unnerved banks and investors and contrib- uted to the freeze-up of the wholesale financial market.

The secrecy and lack of transparency offered by offshore financial havens not only magnify credit and counterparty risks, but also facilitate outright scam or quasi-legal Ponzi schemes, or regulatory avoidance schemes, prevent- ing public authorities from adjudicating in cases when private financial manipulation leads to systemic risks and public losses Palan Like many subsequent casualties of the global credit crunch, the Northern Rock crisis has highlighted controversies about how, in the contemporary financial system, private financial gains and socialized economic losses are addressed by political leaders.

These figures might pale in comparison to the large bonuses that compa- nies like Goldman Sachs or Barclays paid out to their senior executives in , a year after the credit crisis. Treanor , the episode of Northern Rock and the unresolved dilemmas of its securitization vehicles raise concerns about the spread and longevity of Granite-like schemes across the global financial system and its distressingly large shadow component.

It also leads to the question of how many other companies might be continuing to benefit from similar schemes through the use of structured finance and complex investment pyramids. Conclusion The arrangement that Northern Rock set up with its Jersey-based SPE illustrates one of the problems that financial markets are facing nowadays.

The British government accepted the arrangement, having swept under the carpet the complex legal situation it found itself in. Private investors, however, are not so forgiving. As Hyman Minsky warned us, stability is destabilizing: an ambiguity of ownership structures, as well as the concealed risks associated 16 In November , four years after the crisis began, the saga of Northern Rock came to an end.

During periods of dis- tress or crisis, however, the use of securitization structures proves extremely damaging, ampli- fying the connections between the hidden nodes of the financial system and thus magnifying systemic risk.

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